Microsoft Office 365 on pace to becoming billion dollar business

Six months after the launch of Windows 8 and shortly after a quarterly earnings report that surprised some with its solidity, Microsoft watchers are asking:

Is the company the slow-yet-steady tortoise that's gaining on the flashier hares of the business — the Googles and Apples?

Or do the plunging PC market, lukewarm response to Windows 8, and still-minuscule presence in tablets and smartphones foretell an ominous future?

And what should people make of recent news such as activist investor ValueAct Holdings' market-moving investment in Microsoft largely based on its cloud technology potential, official confirmation that the company is working on smaller Windows-based touch devices, and rumours of all the changes coming with "Blue," the wave of sweeping updates ahead for many Microsoft offerings?

The consensus among analysts seems to be that Microsoft is a company in transition, experiencing growing pains and pockets of great promise as it moves from dominance in a world centred on Windows and PCs to becoming a company that delivers services and devices.

While the "services" part of the equation is taking off — Office 365, the subscription model for Microsoft's Office suite, is on pace to become a $US1 billion business by the end of June, for instance — it's not doing as well on the "devices" side, other than with its Xbox console.

And while the growth curve for Windows is flattening, Office remains strong, and Microsoft's Server and Tools business, which encompasses products and services aimed at corporate use, continues to grow steadily each quarter.

"A lot of people fail to recognise that Microsoft has a lot of diversification," said Al Gillen, an analyst with research firm IDC. "If the Windows client business ceased to grow ever again, and I don't think that will happen, the other divisions in the company are moving along without being held back by the Windows business.”

That said, the Windows business is still among the top revenue-generating divisions at Microsoft and perhaps the most closely associated with the company.

Many analysts saw that as a relatively good performance, given that PC shipments went down about 11 per cent to 14 per cent during that quarter, according to research firms Gartner and IDC.

But veteran Microsoft analyst Rick Sherlund, with investment bank Nomura, points out that profits, after the adjustments, were down 20 per cent year-over-year in the division.

"The slow PC sales showed up in lower profits, which was masked on the revenue side in the form of the sale of hardware," Sherlund said.

By "hardware," Sherlund means Microsoft's branded tablets, the Surface Pro and Surface RT, which, though widely reported to not have sold as well as Microsoft had expected, contributed to the division's revenue.

The problem is, the profit margin on the hardware is lower than for software, Sherlund said.

In its news release on the declining PC shipments, IDC placed a large part of the blame squarely on Windows 8, saying "the radical changes to the user interface, removal of the familiar Start button, and the costs associated with touch have made PCs a less attractive alternative to dedicated tablets and other competitive devices."

Initially, people will buy those ultrabooks — ultrathin and lightweight laptops — for use as notebooks, he said. "But over time, they'll begin to use more and more touch, and as more content is available through the touch capabilities, people will begin to use it more as a tablet."

But the risk, he said, is that even after Haswell ships, people don't buy ultrabooks, and instead turn to cheap Chromebooks, just as they're already turning to tablets.

"What's at stake here is a lot of high-margin businesses," said Sherlund, who added that he thinks it's important for Microsoft to get Office onto Android and iOS devices. "The company's on the slippery slope of declining PC sales. It's critical that Microsoft take advantage of multiple platforms and not just Windows."

Another move that may help Microsoft is "Blue," the internal code name for a wave of updates expected this year for Microsoft products such as Windows and Windows Phone.

Microsoft has not said much officially about Blue, aside from a blog post from corporate communications head Frank Shaw, who wrote: "Product leaders across Microsoft are working together on plans to advance our devices and services, a set of plans referred to internally as 'Blue.' "

But rumors have abounded, including that Windows Blue will see the return of the Start button familiar to users since Windows 95 — though it's unclear whether that button will bring up the traditional Start menu or whether the button will merely exist as a way of getting back to Window 8's square-tiled Start screen. The other persistent rumour is that Windows 8 users will have the option to boot directly to desktop, bypassing the tile-screen interface altogether.

It's noteworthy that much of the speculation centres on these screens because they constitute the biggest changes Microsoft made in developing Windows 8. Those changes have been something of a lightning rod among critics of the new design.

The company is expected to make more announcements about Blue at Build, its annual conference for independent developers, happening this year in June.

Michael Yoshikami, chief executive of money-management firm Destination Wealth Management, says that "the rumours really swirl around: Are they going to be able to make it more user friendly, so it's less unfamiliar? In my view, they really don't have a choice. They're going to need to do that, given the rather tepid response by customers."

Even as the company's flagship Windows division stalls, though, its Business division, which includes cash cow Office, and Server and Tools continue to draw big bucks, thanks largely to corporate customers.

Their success also speaks to a return on the investment the company has made in growing its cloud services, including Office 365 and its Windows Azure cloud platform.

In April, Microsoft expanded its Windows Azure capabilities to compete even more directly with Amazon Web Services and said it would match Amazon's prices for services such as computing, storage and bandwidth.

Research firm Forrester called it a "bold move," saying "Microsoft hasn't just entered the public cloud market, it's kicked the door in."

It's an overdue move, according to IDC's Gillen. "Let's say Microsoft's doing the right things. I don't think they're doing it fast enough."